China's planned iron ore futures a threat to dominant swaps market

* Dalian exchange may launch iron ore futures before
year-end

* Latest China effort to influence iron ore pricing

* Yuan-denominated contract seen key to liquidity

By Manolo Serapio Jr and Ruby Lian

SINGAPORE/SHANGHAI, Oct 8 China's imminent
launch of its first iron ore futures contract could pose a
threat to the $28 billion swaps market in the commodity by
exploiting massive untapped hedging potential at home.

The contract to be offered by the Dalian Commodity Exchange
likely before year-end will be China's latest stab at boosting
its power to price the world's second-largest traded commodity
after oil as a more volatile iron ore market exposes its legion
of steel mills to more risks.

By being the first yuan-denominated iron ore futures
contract, the Dalian exchange can easily draw on the growing
hedging appetite in China, a market that bourses in Singapore,
the United States and Europe have been trying to tap for years.

Beijing has kept a tight rein on overseas derivatives
trading by state-owned firms after many lost billions of dollars
in offshore futures during the global financial crisis.

The lack of a domestic hedging tool has led Chinese
companies to increase their use of the U.S. dollar-denominated
cash-settled swaps offered by the Singapore Exchange (SGX)
and CME Group.

"The market is in China, so Dalian's futures will attract a
big number of domestic companies because this can help them
avoid currency volatilities and restrictions which is a big
challenge to Singapore's swaps," said Zhao Qian, a senior broker
with CITIC Securities Futures in Shanghai.

"In the longer term, Beijing hopes to gain more pricing
power via its own futures and it is hoping it can become a
market benchmark."

China buys at least 60 percent of the world's seaborne iron
ore and last year that reached a record 744 million tonnes,
almost seven times the size of swaps cleared by the Singapore
Exchange, pointing to the huge hedging opportunity in China.

"There's no doubt the Dalian exchange will do a lot because
there is a hell of a lot of untapped liquidity in China that is
not trading iron ore swaps," said a Singapore-based broker.

With more than 127 million tonnes traded last year, the
swaps market accounts for just over a tenth of the 1.1 billion
tonnes of seaborne iron ore sold annually.

But the volume is rapidly increasing. In January to
September this year, nearly 210 million tonnes of swaps have
been traded, valued at $28.3 billion based on the average price
of about $135 a tonne. SGX clears over 90 percent of global iron
ore swaps.

A launch of the futures contract may happen before the year
ends after the Dalian Commodity Exchange secured regulatory
approval in mid-September. It will be the first iron ore futures
contract that is backed by physical delivery.

If the strong debut of China's thermal coal futures on the Dalian bourse is any indication, the iron ore
contract should see brisk demand.

SGX, on its part, is not worried about the Dalian contract
launch, saying it is a complementary product to its swaps and
that there is a market for swaps outside of China.

"If liquidity grows onshore in China, liquidity offshore is
able to grow because you're leaning on another layer," Michael
Syn, head of derivatives at SGX, told Reuters.

"And the Chinese aren't the only ones playing on iron ore.
There's still as many people outside of China who need to hedge
as there are in China," Syn said.

SGX began offering cash-settled iron ore futures in April in
response to regulatory changes in the United States where some
of its clients are. But bulk of its business remained in swaps.

Some market participants say the size of each lot - 100
tonnes based on Dalian's plan - may be too small for big Chinese
mills to hedge and may only draw retail investors looking to
make quick cash. In comparison, each lot of SGX's swaps is 500
tonnes.

Providing adequate liquidity may be a tough task for a
fledgling futures market. Previous attempts to launch iron ore
futures have suffered from low liquidity, including contracts
from the Singapore Mercantile Exchange, India's Multi Commodity
Exchange and Indian Commodity Exchange and CME.

Nonetheless, the market looks headed towards futures,
traders say.

"Swaps brokers are very well aware that this will eventually
happen, futures is the way to go. These brokers should start
looking for jobs," said a Singapore trader who handles physical
trades.

Reuters is the news and media division of Thomson Reuters. Thomson Reuters is the world's largest international multimedia news agency, providing investing news, world news, business news, technology news, headline news, small business news, news alerts, personal finance, stock market, and mutual funds information available on Reuters.com, video, mobile, and interactive television platforms. Learn more about Thomson Reuters products: